Voluntary cancellation of shares with no compensation – transfer pricing laws do not apply

by Daria Walkowiak-Dobner and Jakub Zawadzki

14 April 2021 

Chapter 1a of the Corporate Income Tax Act of 15 February 1992 (the CIT Act), i.e. provisions on transfer pricing, does not apply to the voluntary cancellation of shares in a limited liability company with no compensation. This is the legal interpretation of the law presented in the judgment of 17 November 2020 issued by the Provincial Administrative Court (PAC) in Poznan (file no. I SA/Po 453/20).

According to Article 199(1) of the Code of Commercial Companies of 15 September 2000 (the CCC), the cancellation of shares means that the company acquires the shares. The cancellation of shares may be voluntary, i.e. with the shareholder’s consent, or compulsory, i.e. without the shareholder’s consent. Cancellation of shares requires a resolution to be adopted by the meeting of shareholders. Based on Article 199(3) CCC, a shareholder may consent to the cancellation of his share without any compensation.

Cancellation of shares as a “controlled transaction”?

The case in question was about a company which cancelled its shareholder’s shares voluntarily and without any compensation. The company’s mission was to support agricultural business conducted by the shareholders on their own individual farms. The company had five shareholders who dealt with agricultural production. Three shareholders decided to leave the company as they discontinued the agricultural production, while the other two decided to stay in the company. The shareholders left the company by voluntarily having their shares in the share capital cancelled.

The shareholders whose shares were cancelled and the company were associated. Moreover, the shareholders in the company were related by blood or affinity of second degree. As the shareholders were related by blood/affinity, it was necessary to consider the transfer pricing aspects. However, the company was in doubt as to whether the cancellation of shares was a “controlled transaction” in the meaning of the CIT Act. Therefore, the company applied for an advance tax ruling.

In the application the company explained that the family relationship between the company and the management board members was irrelevant for the cancellation of shares and the terms of the cancellation. The company argued that the relationship did not affect the terms of the cancellation of shares because of how the voluntary cancellation of shares worked in general, especially because of no involvement of the appealing party in the decision-making on the cancellation of shares and the terms of that cancellation. The company claimed that even though the cancellation of shares was a form of a share acquisition by the company for the purpose of cancellation, and as such might be treated as a transaction between the company and the cancelled shareholder, it was difficult to treat it as a “business activity” which the definition of a controlled transaction required.

The Head of the National Tax Information Service (NTIS) rejected the taxpayer’s argument claiming that the term “transaction” had double meaning in everyday language. It could be understood as a commercial operation to purchase or sell goods or services, as well as a commercial contract for purchase or sale of goods or services. The Head of NTIS argued that the definition of transaction covered all legal transactions which transferred ownership of goods. The term “transaction” was a synonym of “contract”. Therefore, the cancellation of shares, whether voluntary or compulsory, fitted the definition of transaction. Moreover, the situation involved associated enterprises and, therefore, transfer pricing documentation had to be drawn up if the transaction value thresholds referred to in Article 11k(2) CIT Act were exceeded.

Since the Head of NTIS rejected the company’s standpoint, the company appealed against the advance tax ruling in the part which found that standpoint incorrect.

Administrative court’s assessment

The Provincial Administrative Court in Poznan disagreed with the tax authorities’ advance ruling. The court reversed the ruling on the basis of substantive and procedural violations. The court presented a different interpretation of Article 11a(1)(6) CIT Act. The judgment said that the Head of NTIS unlawfully invoked the everyday language to interpret the term “transaction” claiming that it was undefined. The PAC in Poznan pointed out that a “controlled transaction” had a legal definition in Article 11a(1)(6) CIT Act.

However, the court did not agree with the company entirely. They ruled that the sale of shares to the company in order to cancel them fell under the category of business activities. These activities involved shares in a limited liability company which represent a property right to which corporate and financial rights are attached. Consequently, the sale of shares to the company in order to cancel them falls under the category of business activities.

Transposing the foregoing consideration to the definition of a controlled transaction, the court arrived at the conclusion that the shares were not cancelled on terms affected or imposed by the company-shareholder relationship. This meant that there were no actions of the parties that were motivated by their relationship as the cancellation had to be based on the company's articles of association. The CCC does not prohibit – it actually allows – cancellation without compensation, as long as the shareholder consents to this. Consequently, the PAC in Poznan agreed with the company's viewpoint that chapter 1a of the CIT Act did not apply to the voluntary cancellation of shares in a limited liability company with no compensation The judgment is not final.

Expert's opinion

So far only tax authorities have classified the voluntary cancellation of shares as a controlled transaction. The case in question confirmed the existing practice of tax authorities which defined controlled transaction as broadly as possible to include all dealings between associated enterprises. Although the PAC in Poznan held in its judgment that the voluntary cancellation of shares could be a business activity, this did not mean that a controlled transaction was made. No doubt, the court's judgment is more favourable to taxpayers. However, the judgment is not yet final. So, unless tax authorities change their approach, you should be aware of a potential dispute over this issue.